Estimating Cost of Capital Quiz

Estimating the Cost of Capital

• Managers estimate the cost of capital to evaluate investment projects, determining their net present value (NPV)
• The cost of capital includes a risk premium compensating investors for project risk
• The Capital Asset Pricing Model (CAPM) helps estimate the risk premium and cost of capital
• The cost of capital depends on the investment's risk, measured by its beta relative to the market portfolio
• The market portfolio represents the non-diversifiable risk in the economy and is well diversified
• Investments with similar risk have the same sensitivity to market risk, measured by beta

Equity Cost of Capital

• The cost of capital for a firm's stock is its equity cost of capital, calculated using the CAPM equation
• The CAPM equation calculates the cost of capital using the expected return and risk-free interest rate
• A higher beta indicates a higher sensitivity to market risk, resulting in a higher cost of capital
• To implement CAPM, the market portfolio and its expected excess return have to be identified
• The investor's willingness to hold market risk is measured by the market risk premium
• The risk-free rate is determined from U.S. Treasury securities (matching maturity) or highest-quality corporate bonds

The Market Portfolio

• The market portfolio comprises all securities, with weights proportional to their market capitalization
• A value-weighted portfolio is an equal-ownership portfolio, maintaining value weighting through price changes
• Common proxies representing the market portfolio are the S&P 500 and the Wilshire 5000 indexes
• The S&P 500 tracks the largest 500 U.S. stocks, while the Wilshire 5000 includes almost 80% of the U.S. stock market in terms of market capitalization

Beta Estimation

• A fundamental approach to estimating market risk premium involves assessing future cash flows and evaluating discount rates consistent with current index levels
• Beta is calculated using historical returns and represents the sensitivity of a security's return to the market portfolio's return
• Linear regression helps identify the best-fitting line for a security's excess return versus the market's excess return
• Beta represents the percentage change in a security's return per 1% change in the market portfolio's return

The Debt Cost of Capital

• Debt yield usually overestimates the actual expected return due to default risk
• The expected return for debt can be estimated using the CAPM or by examining historical default rates.
• Considering firm's bond ratings and recession periods helps estimate the expected return for debt
• Debt beta represents a bond's sensitivity to market risk.
• A firm's cost of capital has to be adjusted for potential default risk using a bond's loss rate or recovery rate.

Project Cost of Capital

• Estimating a project's cost of capital involves identifying comparable firms in the same business line
• All-equity comparable firms (no debt) provide straightforward beta and cost of capital estimates, using the asset betas
• Levered firms (with debt) are more complex. Determining the comparable firm's asset beta is done using the firms' unlevered betas
• This unlevered beta is then used to estimate the project cost of capital using the CAPM

Estimating Industry Asset Betas

• Industry asset betas are calculated by averaging comparable unlevered betas of several businesses in the same line of business
• Differences in firms' betas are often due to differences in leverage. Combining unlevered betas from multiple companies can reduce estimation errors